What Is Venture Capital and Is It Right for Me?

If you want to start a business, you're going to need money to fund it.

Posted: 06/20/2013 08:00 AM EDT

So you have decided to start a new business. Maybe it’s a technology start-up, or a media platform, or a government contracting firm or a new retail chain. No matter what type of business you undertake, one thing is certain you will need money to fund it!

A business requires capital to lease office space, purchase equipment and supplies, develop products and inventory, and to pay employees. Some entrepreneurs choose to dip into personal savings and assets to get their businesses off the ground. Other companies, particularly those in the service industry, bootstrap their way to profitability by getting a small initial investment to get the business up and running and using profits from sales to grow the business. A third option is to borrow money from a bank or other lender. For a company with significant cash flows and tangible assets, debt financing may be one of the cheapest forms of financing available.

And then there is venture capital. The term “venture capital” still elicits a wide array of reactions, depending upon who you talk to. For entrepreneurs who don’t have experience with this type of financing, the notion of venture capital can be a bit daunting often because they are not exactly certain how venture capital works and whether it is right for their business.

Venture capital is not for every business. It is a type of funding provided to early-stage, high-risk and high-growth startup companies, often in industries such as technology, social media, telecommunications, biotechnology and software. A venture capitalist makes money by owning a significant equity stake in the companies in which it invests. Those companies typically have an innovative technology or business model that can scale exponentially. Venture capitalists usually invest after a seed funding round with a goal of generating returns through a liquidation event, such as a sale of the company or an initial public offering (IPO) of the company’s stock within three to seven years after the initial investment.

Getting a venture capital investment is not at all like getting a loan from a bank or other lender. Lenders provide funding in exchange for a company’s promise to repay that capital, along with interest at a stated rate. Lenders have a right to repayment regardless of whether the business achieves its milestones and becomes profitable or not. On the other hand, a venture capitalist's ultimate return depends on the growth and profitability of the business and whether the business can eventually “exit” through a sale of the company’s stock or assets to a willing buyer or an IPO.

Venture capital investments range from about $500,000 up to as much as $10 million. With that much money at risk, venture firms have to be very selective about which companies they will invest in. They receive hundreds or thousands of business plans every year, but may only invest in a few companies in any given year, and those investments are consummated only after an exhaustive due diligence and legal negotiation and documentation process that can take many months to complete.

The key attributes venture capitalists seek in any investment opportunity are innovative technologies or businesses, a potential for high growth, a well-developed business model and a strong management team whose members have a proven track record of success. Even firms that market themselves as “early stage” investors increasingly require companies to show significant customer or revenue traction before they will invest. It is also important to a venture capitalist that a company’s founders have significant “skin in the game,” meaning those founders believe so strongly in their idea that they themselves have made significant investments of cash and sweat equity before going out to seek outside funding.

If a company succeeds in getting a venture capital investment, that funding will mark the beginning of a long relationship. Venture capitalists monitor the companies in their portfolios very closely. They will typically require at least one seat on a company’s board of directors and have certain information rights and rights to approve (or veto) significant company actions if they believe those actions could put their investments at higher risk. They will confer regularly with management to determine the company’s progress and to offer assistance with strategy development and tactical execution. For some, this level of involvement by venture capitalists is a welcome opportunity to access ideas, experience and networks that would otherwise elude them. For others, it can start to feel like an encroachment on the autonomy of the company’s management team.

As desirable as the idea of getting a venture capital investment may be, entrepreneurs must keep in mind that venture capital financing is very expensive. Early stage investors can acquire as much as a third or more of a company’s equity, depending upon the venture’s pre-investment valuation. They are usually entitled to cumulative annual dividends that accrue over the life of the investment and liquidation preferences that enable them to get their money back plus dividends (and potentially other premiums) before the company’s founders can cash out completely.

Venture capital can be the right solution for the right type of company. It is most suitable for scalable businesses that have significant capital requirements that cannot be financed by debt and that are too small to raise money through a public offering of stock. Getting a venture capitalist to invest in a company is no easy feat, but under the right circumstances it can mean the difference between having a great concept and having the potential to develop that concept into a valuable going concern the likes of Google or Facebook.

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 (Photo: Teekid / Getty Images)

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